Dale R. Vlasek
McDonald Hopkins LLC
P: 216.348.5452
E: dvlasek@mcdonaldhopkins

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A cash balance retirement plan is a defined benefit plan that gives the appearance of operating more like a 401(k) plan than a traditional defined benefit plan.

How a Cash Balance Plan Works

Like a 401(k) plan, each participant has an account and his or her benefit is based on the value of the account. However, unlike a 401(k) plan, this cash balance plan account is only hypothetical. It exists only on paper and is for recordkeeping purposes only. No assets are segregated in the account and the participant does not direct the investment of the account.

The plan’s formula provides that a hypothetical amount will be credited to the hypothetical account. There are a variety of ways the amount can be calculated. For example, the amount can be calculated as follows:

• A fixed dollar amount (such as, $10,000 a year)
• A percentage of compensation (such as, 5% of compensation)
• A multiple of compensation over a set amount (such as, 10 times compensation over $90,000)

Usually, the amount is credited to the account annually at the end of the cash balance plan year.

The account is then credited with “interest” based on a rate specified in the plan. Although the interest rate can be any rate, for actuarial reasons, it is best to apply the rate used to convert benefits to single sum payments. Normally, the rate used is the 30-year Treasury Rate. This rate is about 5%. The interest rate can be credited monthly or annually. Normally, however, cash balance plans credit the interest annually. The interest credited is unrelated to the actual investment returns in the plan.

The benefit a participant receives is the actuarial equivalent of the hypothetical cash balance plan account. Because a cash balance plan is a defined benefit plan, it is required to provide a joint and 50% survivor annuity as the normal form of benefit payment. As a matter of course, cash balance plans permit the participant to waive that form of benefit payment (with spousal consent) and elect a single sum payment. The single sum would be essentially equal to the hypothetical account balance.

 Actual Deductible Contributions

The actual contribution to the cash balance retirement plan determined by the plan’s actuary. Typically, the contribution is essentially equal to the hypothetical amount being credited to the hypothetical account. However, if investment returns are particularly poor over a period of time the actual contributions may need to be higher.

Cash Balance Example

The following example demonstrates how a cash balance retirement plan might work for a particular participant. Assume a participant, age 55, has compensation of $175,000 a year, which increases at 3% per year.

In this example, the cash balance plan credits his or her account with an amount equal to 20% of compensation and uses a 5% interest credit. In the 10 years until age 65, his or her account might look as follows:

The Chief Advantage of Cash Balance Retirement Plans

If the participant terminates employment in 2017, he or she will be entitled to a single sum payment of $498,711.93. The participant could then roll that benefit to an IRA or another qualified plan.

Thus, the chief advantage of a cash balance retirement plan is that it is structured like a 401(k) account plan, but permits significantly larger contributions and consequently, significantly larger benefit payments.

©McDonald Hopkins LLC (2008) Dale Vlasek